As the year unfolds, the U.S. market and economy continue to charge ahead while returns elsewhere are lagging. It is said, ‘the market climbs a wall of worry’ and there are a number of market risks that have our attention. These include expanding trade tariffs, various geopolitical dangers, rising short-term interest rates, accelerating inflation, signs of decelerating growth in some parts of the globe and negative investor sentiment in certain foreign markets.

U.S. EQUITY MARKETS
The U.S. equity market steadily marched to new highs during the third quarter with the S&P 500 gaining 7.7% and smaller stocks doing about half as well with the Russell 2000 rising 3.6%. Corporate earnings have grown by better than 20% so far this year, benefitting from lower tax rates and strong consumer spending. Recent readings of business and consumer sentiment have registered at or near all-time highs. Wages are on the rise and there are more job openings than people looking for work. Unemployment is holding below 4.0%, the lowest level in more than a decade. The U.S. economy appears to be accelerating and we expect fullyear GDP growth to approach 3.0%, though probably growing in excess of that level currently. So far, the impact of rising interest rates, a stronger dollar, and trade tariffs have had but a negligible impact on the economy and earnings. It’s important to note that we are in the second longest running business expansion since the great depression. However, the level of absolute economic growth has been just over half that of a normal expansion. Most economic and financial indicators point to continued growth for at least another 12-18 months, but we are mindful of developing risks (as outlined in our opening paragraph), which cloud the more distant future. We don’t believe economic cycles have been suspended so we recognize that, at some point, investors will grapple with economic and market conditions that are less favorable than today.

INTERNATIONAL AND EMERGING MARKETS
Foreign equity markets did not fare as well as the U.S. during the third quarter as investor sentiment soured over expanding trade tariffs and returns further hampered by a stronger U.S. dollar. Although international markets rebounded in later September, returns were still mixed for the quarter with the MSCI EAFE gaining 1.4% and the MSCI Emerging Markets losing -1.1%. Aside from trade tariffs and currency concerns, investors are also scrutinizing the pace of global economic growth. Earlier this year, most global economies were accelerating in tandem. More recently, however, there are signs that economic growth rates may be waning in Europe and China. And countries such as Turkey and Argentina are capturing negative headlines relating to various economic and monetary challenges in those countries that have spooked investors. In our view, broader global economic conditions remain positive as growth rates are expected to remain above 3.0% as we move into next year, however, prospects appear to be diverging across major economies.

TRADE TARIFFS IN PERSPECTIVE
Much of the current ‘trade war’ centers on the U.S. and China. Earlier this year, the U.S. applied 25% tariffs on $50B worth of goods that are imported from China and in September applied 10% tariffs that impact $200B worth of imported Chinese goods. For its part, China matched the first volley of tariffs with its own $50B tariff and added another $60B in September with tariff amounts ranging between 5-10%. For those doing the math, the U.S. imports just over $500B worth of goods from China each year whereas China imports only $110B worth of goods from the U.S. This means, the U.S. has imposed tariffs on about 50% of Chinese goods, but China has reached a tariff level equal to 70% of goods it imports from the U.S. In response to U.S. tariffs, China is seeking to protect economic damage to its economy by fostering growth in other areas and is substituting U.S. imports for similar goods it can import from other countries. The adverse impacts of tariffs include higher business costs and lower corporate profits, as well as higher consumer prices. In theory, the impact of announced tariffs may impact China more than the U.S., although we would view both sides as net losers in economic terms. To put this issue in perspective, keep in mind the size of the total U.S. economy is $18 trillion and China’s economy is $10 trillion. While tariffs likely pose a headwind to both countries (and potentially more so to China), the ultimate harm posed may be marginal as each country has the means to pursue measures that blunt the deleterious impact. In our view, the bark of negative investor sentiment relating to this issue may be worse than the actual bite, at least to this point. However, we continue to monitor this situation very closely as an expanding trade war could indeed pose a legitimate risk to the global economy and financial markets. Although NAFTA was recently resolved, we believe the issue with China may not meet with any resolution until after U.S. mid-term elections in November.

BONDS
Positive domestic economic trends and percolating wage and price inflation are giving the Federal Reserve ample room to continue hiking interest rates. The Fed delivered its third quarter-point rate hike of the year in September. Short-term market rates have responded by moving higher, but rates for terms beyond 5-years have moved to a much lesser extent. For example the 10-year treasury rate ended the quarter at 3.06%, marginally higher than 2.85% when the quarter began in July. This dynamic has led to a flattening yield curve, meaning the difference between short and long-term rates has diminished. This yield pattern indicates market skepticism that rising short-term rates will persist for an extended period of time. Historically, this pattern has indicated a cautionary flag relating to the economy. However, credit spreads (the difference in rates between high grade and low grade debt) also remain very narrow, reflecting a positive market view of the economy. In this environment, most bonds have generated nominal, but positive returns.

CONCLUSION
The S&P 500 has been the best performing major index this year so any diversification beyond U.S. large cap stocks has diminished returns. This happens occasionally, but doesn’t negate the value and importance of diversification. We also have meaningful exposure to areas of the market that we believe are undervalued relative to U.S. stocks, including Emerging Markets, which have been impacted by a strong dollar and trade tariffs. In our view, these headwinds are unlikely to persist over the long run. The extended positive economic cycle we now enjoy here in the U.S. will someday shift to a headwind, reflecting yet another transitory phase of the overall cycle. So we continue to stress a consistent and disciplined investment approach based on individual circumstances and objectives. We believe this approach provides a steady course regardless of which way market winds happen to blow.

DISCLOSURESConfluence Wealth Management, LLC is a registered investment adviser with the United States Securities and Exchange Commission (SEC). Registration of an investment advisor does not imply any level of skill or training. As a registered investment advisor, Confluence Wealth Management is not engaged in the practice of law or tax preparation. As such, you are encouraged to consult with a CPA or tax professional about your individual situation prior to implementing any tax related strategies. See All Disclosures